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Credit Creation & Monetary Policy
Credit Creation & Monetary Policy
MONETARY POLICY
Main Functions of RBI
Monetary Authority:
Formulates implements and monitors the monetary policy.
Objective: maintaining price stability and ensuring adequate
flow of credit to productive sectors.
Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for
circulation.
Objective: to give the public adequate quantity of supplies of
currency notes and coins and in good quality.
Main Functions of RBI
Developmental role
Performs a wide range of promotional functions to
support national objectives.
Monetary Aggregates
M2 = M1 + Time Liabilities Portion of Savings Deposits with the
Banking System + Certificates of Deposit issued by Banks +
Term Deposits of residents with a contractual maturity of up to
and including one year with the Banking System (excluding
CDs)
= Currency with the Public + Current Deposits with the Banking
System + Savings Deposits with the Banking System + Certificates of
Deposit issued by Banks + Term Deposits of residents with a
contractual maturity up to and including one year with the Banking
System (excluding CDs) + 'Other‘ Deposits with the RBI
Monetary Aggregates
Government
13.0 million Net Worth 3.0 million
debt
Required
10.0 million
Reserves
103.0 103.0
Total Total
million million
How the banks create money?
Glen Echo Bank Balance Sheet (Add $1.0 million deposit from you)
Assets Liabilities
Loans
$ 80.9 million Deposits $101.0 million
Outstanding
Government
13.0 million Net Worth 3.0 million
debt
Required
10.1 million
Reserves
Assets Liabilites
A 100 80 20
B 80 64 16
C 64 51.2 12.8
D 51.2 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68
K 10.74
Total Reserves:
89.26
= 1/r.r.
This formula stems from the fact that the sum of the "amount loaned out" column above
can be expressed mathematically as a geometric series with a common ratio of 1 − R
In reality there are a number of leakages from the above scenario that will reduce the value of
the multiplier:
People may not deposit all of their cash into the banking system. Besides the money we keep
in our wallets, we may save some of our money outside the depository banking system.
Banks may not loan out all potential reserves, choosing to keep excess reserves.
Monetary Aggregates
Monetary Liabilities of RBI
High Powered Money: Monetary Liabilities of RBI
+ Government Money
Monetary Liabilities of RBI = Currency with the
Public + Reserves + ‘Other’ Deposits with RBI
Reserves = Vault cash + Deposits with RBI +
Excess Reserves
Money Multiplier
Money Supply = money multiplier * HP
Money Supply = money multiplier * ML
Mm = Money Supply / ML
Mm = C + DD/ C +r (DD)
Mm = c + 1/ c + r
(Dividing numerator and denominator by DD)
COVID
Long Term Repo Operations (LTRO)
Targeted Long Term Repo Operations (TLTRO)
Open Market Operations
The most effective tool the RBI has is the buying
and selling of government securities in its open
market operations. Government securities include
gilt edged bonds, notes, and bills.
Open Market Operations
The RBI buys bonds from banks.
Bank reserves and the monetary base increase.
Banks don't want money sitting in their vaults, earning zero return, so they
attempt to loan out the money.
To attract borrowers, banks lower the interest rates that they charge.
The businesses and individuals who borrow the money from the banks spend it
on goods and services.
These expenditures create incomes that are deposited into the banking system.
The money supply increases by a greater amount than the original RBI
purchase of bonds because of the money multiplier.
Increases in investment activity by businesses will increase aggregate demand
and the growth rate of GDP.
Operation Twist
Discount Window Lending
Discount rate is the interest rate that the RBI charges banks for
short-term loans. Changes in the discount rate typically occur in
conjunction with changes in the Bank rate.
Thus we can say that this serves duel purposes i.e. it not only ensures
that a portion of bank deposits is totally risk-free, but also enables RBI
to control liquidity in the system, and thereby, inflation by tying the
hands of the banks in lending money.
Statutory Liquidity Ratio
Statutory Liquidity Ratio (SLR) is a term used in
the regulation of banking in India. It is the amount
which a bank has to maintain in the form:
Cash
Gold valued at a price not exceeding the current market price,
Unencumbered approved securities (Government securities or Gilts come under
this) valued at a price as specified by the RBI from time to time.
Statutory Liquidity Ratio
The objectives of SLR are:
To restrict the expansion of bank credit.
Government securities.
To ensure solvency of banks. A reduction of SLR
SLR restricts the bank’s leverage in pumping more money into the
economy. On the other hand, CRR, , is the portion of deposits that the
banks have to maintain with the Central Bank.
The other difference is that to meet SLR, banks can use cash, gold or
approved securities whereas with CRR it has to be only cash. CRR is
maintained in cash form with RBI, whereas SLR is maintained in liquid
form with banks themselves.
Liquidity Adjustment Facility
Liquidity Adjustment Facility (LAF) was introduced by RBI during
June, 2000 in phases, to ensure smooth transition and keeping pace
with technological upReverse
gradation.
Repo Rate is a mechanism to absorb
the liquidity in the market, thus restricting the
borrowing power of investors. Reverse Repo
Objective : The funds under
Rate LAF
is when are borrows
the RBI used by the from
money banks for their day-
to-day mismatches inbanks when there is excess liquidity in the
liquidity.
market. The banks benefit out of it by receiving
interest for their holdings with the central bank
Tenor :Under the scheme, Reverse Repo auctions (for absorption of
liquidity) and Repo auctions (for injection of liquidity) are conducted
on a daily basis (except Saturdays).Repo rate is the rate at which the central
bank of a country (Reserve Bank of India in
case of India) lends money to commercial
banks in the event of any shortfall of funds.
Repo rate is used by monetary authorities to
control inflation.
Marginal Standing Facility (MSF)
Banks can avail overnight, up to one per cent of
their respective Net Demand and Time Liabilities
(NDTL).
MSF is a very short term borrowing scheme for scheduled
commercial banks. Banks may borrow funds through MSF during
severe cash shortage or acute shortage of liquidity.
Banks often face liquidity shortfalls due to mismatch in their
deposit and loan portfolios. These are usually very short term and
banks can borrow from RBI for one day period by offering dated
government securities.
Market Stabilization Scheme (MSS)
The bills/bonds issued under MSS would have all the attributes of the
existing Treasury Bills and dated securities.
The Reserve Bank will decide and notify the amount, tenure and timing
of issuance of such treasury bills and dated securities. Whenever such
securities are issued by the Reserve Bank for the purpose of market
stabilization and sterilization, a press release at the time of issue would
indicate such purpose.
Latest Important Banking Sector Data
(SLR) Facility
2019 2020 2019 2020
19.50% 18% 5.40% 4.25%
RBI Rates
Expansionary Monetary Policy
Contractionary Monetary Policy
Policy Lags
Time lags that occur between the onset of an economic problem and the
full impact of the policy intended to correct the problem.
Policy lags come in two broad categories:
inside lag (getting the policy activated)
* recognition lag,
* decision lag, and
* implementation lag.
outside lag (the subsequent impact of the policy).
* impact lag.
Policy lags can reduce the effectiveness of business-cycle stabilization
policies and can even destabilize the economy. Policy lags, especially
inside lags, are often different for monetary policy than for fiscal policy.
Monetary Policy
Can be made ineffective:
In times of recession